Nouriel Roubini: The Mother and Father of All Bubbles
Nouriel Roubini is not known for his optimism. A perennial permabear who bears the moniker Dr. Doom, Roubini is rarely sanguine. That said, he correctly called the housing bubble in the lead-up to the global financial crisis, and his analysis, while rarely bullish, has shown remarkable accuracy over the years.
So when Roubini talks, it’s well worth a listen. With that in mind, we spoke with him to get his take on a number of market phenomena, including the crypto craze, the current state of monetary policy and global growth, and more.
Below is a lightly condensed and edited transcript of our discussion.
CFA Institute: Dr. Roubini, when you spoke with us in 2015, roughly six years after the financial crisis, the focus was unconventional monetary policy and how it had yet to deliver a robust global recovery. How have your views evolved since then?
Nouriel Roubini: Since 2015, the global economy has gone through periods of expansion where growth is positive and accelerating and periods of a slowdown where growth is decelerating. There were two risk episodes. One was August–September 2015, and then the other one was January and February 2016. In both episodes, there were worries about China, and in the second episode, there were also worries about US growth stalling, signaling a slowdown in Europe, Brexit worries, and oil prices falling.
And in each one of those two episodes, there was a short-lived yet quite significant global equity market correction associated with a slowdown. Then we’re in an expansion, then a slowdown again in the first half of 2016, and then [more of a slowdown] starting in the middle of 2016 with some of the clouds and worries about the US, China, oil, bad policy, impacts of Brexit. Once those clouds were removed, for a year and a half or two, the global economy was growing in an expansion.
The year 2017 was truly one of global expansion when there was a synchronized acceleration of growth in the US, Europe, Japan, most emerging markets. But then last year, that expansion became less synchronized. The US and China were still growing relatively robustly, but Europe and the eurozone, Japan, a bunch of emerging markets, were fragile.
This recap brings us up to 2019, which is still likely to be a year of positive growth, but I would call it a synchronized slowdown. Most major regions of the world are now slowing down. Some of them just towards potential, but many of them, like the eurozone, may actually start sputtering towards something weaker than their level of potential economic growth.
So the good news might be that we don’t have a global recession, but since 2015 maybe we’ve had only a period of 18 to maximum 24 months of a true global expansion, from the middle of 2016 to the middle or first half of 2018. And since then, it has been periods of mediocre growth, or slowdown. And now we are in this kind of late stage of the global cycle.
CFA institute was one of the founders of the Systemic Risk Council shortly after the global financial crisis. Since then, some systemic protections were put in place, but others have been walked back. What is your take?
Let’s begin by acknowledging that since the global financial crisis, some of the risks that were in traditional financial institutions like banks have been reduced. There is overall more liquidity, more capital, less leverage. Traditional bank depositors are safer now after reforms were implemented to limit the risk-taking behavior of the regulated financial institutions. But two things have happened that may be an element of concern over time.
One, as you pointed out, the regulatory pendulum is swinging back to say we over-regulated after the global financial crisis and now we should reduce some of these regulations. That process is ongoing in the United States with the Trump administration. There have been stages in the Dodd–Frank legislation and regulation that suggest giving more leeway, even to regulated financial institutions, to take more risk.
And two, the last crisis was a problem of excessive leverage in the household sector, subprime and other mortgages. And banks this time around, they’re beginning to see some excesses in the corporate sector. . . . And some of the risks have moved away from more-regulated banks to less-regulated or unregulated financial institutions — so-called shadow banks.
My concern is that now the pendulum may be going too far in the direction of light regulation and relying excessively on market discipline. Over time, if and when there is a turnaround at some point in that credit cycle, credit excesses may put a wide range of financial institutions at risk.
Where specifically do you see credit building up dangerously?
Well, excessive debt certainly is present in the corporate sector. These excesses manifest themselves in three different ways. The rise of leveraged loans, and covenant lite, is one such area of potential risk.
The second area is that the significant buildup of high-yield junk bonds and the pricing of those junk bonds in terms of spread is maybe too low compared with their potential riskiness.
And three, even in investment grade, now there is this phenomenon of . . . fallen angels: firms that used to be high grade, but have had a deterioration in their financial condition and their rating is falling toward the lower end of that high-yield borderline, with the risk of downgrade to even below investment grade to high-yield junk. And the pricing, again, is not reflected in the fact that previously high-grade firms are not looking at high grade.
Now, the optimists say that debt metrics for the corporate sector are healthy. Debt-servicing ratios are low because both short and long rates have gone up, but only gradually. And people say the profitability of the corporate sector is still high and growth is still, for the US, somehow above potential. GDP growth is 2% to 2.5% depending on how you predict it. So as long as the economy continues to grow and profits are decent, the debt-servicing problems are not going to be severe.
This optimism may be justified right now, but what if there are some shocks? A slowdown of growth, say, or a slowdown of profitability, or a widening of credit spreads? For example, spreads widening can take markets by surprise like it did in the beginning of 2016, when high-yield spreads went from 300 to 900 in a matter of months, or what happened with the leverage loans in the fourth quarter of 2018. Then suddenly something that looked sustainable under one set of financial economic conditions becomes less sustainable.
We are not yet in the last inning of that credit re-leveraging in the corporate sector, but it is the beginning of a significant buildup of vulnerability. Should an economic slowdown occur, it would hurt the corporate debt space a lot. In my opinion, we’re starting to enter a more dangerous zone here.
Speaking of potential vulnerabilities, are you concerned about increasing indexation in the markets? Do you see any systemic implications arising out of such investment approaches?
Index-driven investments displacing active management is, in my view, positive. It has been widely documented that most of the time, active managers underperform on a long-term basis net of fees. Personally, I have most of my investments in these index funds that are very low cost — weighted average fee of 0.10% per year. So why should I pay 1% to 1.5% or 2% plus 20 for stuff that actually doesn’t give me over time any real outcome? Many of these investments are essentially leverage beta. That is why many small investors and even sophisticated ones are going in this direction.
Furthermore, even if there was an economic downturn that leads to dangerous significant correction, I don’t know whether passive investors will be more impulsive than active investors in trying to sell out of their positions. You could even argue that some of the passive investors may have more inertia. Passive investors tend not to time the market and, I would say, are less likely to exacerbate the market cycles.
Some are concerned by the price discovery risk posed by the proliferation of passive investments. My answer is, there’s a lot of passive investment, but there are enough active managers, active analysts, and other activists. These have a clear motivation, so I don’t yet see this trend towards passive investment as either having a real systemic risk or something that impacts price discovery too much.
Now, in the credit space there is a phenomenon that has been pointed out by the IMF [International Monetary Fund], BIS [Bank for International Settlements], and others that says we’ve had massive debt issuance, both private and public sector. These instruments don’t tend to be traded on exchanges. They tend to be illiquid and over the counter, and so the last three years, there has been a growth of specialist credit-focused funders that specialize in direct lending.
Should there be a threat in the credit market, then suddenly, say, high-yield or leverage loans spread widened, if many people were to dump this credit fund, then you could have the equivalent of a bank run. Meaning suddenly there are firms that must sell these assets in an illiquid market, further depressing the price of underlying securities. That leads to further credit spread widening and can cause systemic damage if a bunch of them going belly up.
Another concern is that the underlying is highly illiquid, but passive funds typically offer their investors immediate liquidity so you can sell out of your position as if it was a bank account. It’s more like the repetition of something that looks like the maturity mismatch of traditional banks. So that’s an area that, in terms of systemic risk combined with the mis-pricing of some of these credit instruments, could be a source of stress if and when the credit cycle turns around.
Are there segments of the market that bring out your inner Dr. Doom? Are there any self-evident market assumptions out there that are illusory?
Well, I always try to be a realist. I’m neither negative, pessimist, nor optimist. I apply a reasonably sophisticated analysis to what’s going on in the world and the market, then try to get it right. And, of course, nobody is going get it right all the time.
Are we close to a recession now? There is a lot of concern out there now, 10 years after the crisis, that the typical US cycle does not last for decades. My answer to that is, expansions don’t die a natural death. Australia may be an exception with positive growth now for 25 years. Usually, expansions end because of economic or financial vulnerabilities exacerbated by a variety of policy mistakes. We are probably not going to have a global recession this year, but there is a buildup of excessive debt in the US.
And it’s not just corporate in the US. There is also a buildup of household debt, including student loans and auto loans. And even housing is showing some weakness given the rise in mortgage rates and changes in tax laws that make housing investment less beneficial.
And then there is also buildup of debt across the world. For example, I am keeping an eye on Chinese private debt, real estate lending, as well as state and local government. Some emerging markets are highly leveraged, either in the private and/or public sector, and in Europe we still have some countries where public debt, if there was another economic downturn, could be a source of significant stress. And the first country that comes to mind is Italy. Its government is pursuing populist policies that will eventually lead to recession. The debt dynamic may become unsustainable as well.
Globally, there is too much private and public debt, both foreign and domestic. We are lucky that although the leverage is high, the debt-servicing ratios appear manageable due to low interest rates. However, the process of policy normalization has started and interest rates may gradually go higher. And even if some government bond yield offerings remain low, the credit spread for public and private assets can start widening. This can take place suddenly if the market gets nervous about economic fundamentals or geopolitical risks. So slowly, slowly we may be building up the seeds of the next economic downturn. Picking the exact time when the crisis will hit is almost impossible, but we don’t live in a safe world. We’ve kicked the can down the road in many ways.
One could argue central bankers kicked the proverbial can down the road in the past decade. What policy advice would you give them?
Straight after the crisis, I was sympathetic and in favor of Ben Bernanke’s stance on market policies, because without these, the crisis of 2008–09 could have evolved into Great Depression 2.0. Remember that in the absence of monetary or fiscal stimulus, the stock market crash of 1929 led to the Great Depression when thousands of banks were allowed to fail. Bernanke and his fellow central bankers learned this lesson, and I think their actions, including huge unconventional monetary stimulus, when policy rates went to zero, was necessary. Fiscal stimulus was necessary as was the policy of supporting illiquid but solvent financial institutions.
However, now we are dealing with the legacy of these actions, like the buildup of private and public debt we spoke about earlier. Although low inflation rates may allow the process of policy rate normalization to be very gradual, the sheer amount of debt makes the global economy vulnerable to a severe crisis.
In summary, central banks have not used the years of the recovery too effectively. As the saying goes, “The best time to fix the roof on the house is when the sun shines,” so that it will be safe when the next storm hits. Vulnerabilities in the system are currently hidden and will emerge if and when the next economic downturn occurs.
Bitcoin and cryptocurrencies grew out of distrust for central bankers. You recently expressed strong views on this subject.
Well, I’m an expert of asset bubbles and of financial crisis. I’ve studied so many historical bubbles. I wrote a whole book, Crisis Economics, on bubbles and their busts. I know one when I see one. And, of course, knowing when there is a real bubble — it’s a long and complicated story. But to me, the whole crypto space is one of assets that are not really money. They’re not really a currency. They’re not a scalable means of payment. They’re not as stable in terms of store of value.
And what happened, especially in 2017 when the price of bitcoin went from $2,000 all the way to $20,000 by the end of the year, to me had all the features of a bubble. Especially telling was that by the second half of 2017, there were millions of people who didn’t know anything about finance or portfolio investments, driven by FOMO or the fear of missing out, buying bitcoin and all these other s**tcoins.
To me, it looked like an exponential, parabolic bubble. That’s why I became very vocal towards the end of 2017. And guess what? That bubble started to burst because there was no real fundamental value on these assets. Then even bitcoin, since the peak, has lost almost 85% of its value. And that’s the best one because thousands of these s**tcoins were created as scams and have lost almost all of their value. The top 10 cryptocurrencies, excluding bitcoin, the average loss of value since the peak has been between 92% and 93%.
This was to me the mother and the father of all bubbles. And like every bubble, it went out of control and then went bust, and I was confident enough I was right that this was a bubble. I did the US Senate banking testimony with a 40-page paper calling cryptocurrency out for what it is, and I was very vocal on Twitter against this army of people who were totally delusional. Pleased to say I got this bubble right.
I looked at the three most popular tweets in your Twitter feed expecting they would focus on your work on economic crises. But your hottest posts relate to cryptocurrencies. There’s a lot of passion in this space. Does that give you any pause?
Well, I engage on Twitter and I also have attended many of these crypto or blockchain conferences. I met some of these individuals, and I must say I’ve never seen in my life people who on one side are so arrogant in their views, who are total zealots and fanatics about this new asset class, while at the same time completely and totally ignorant of basic economics, finance, money, banking, central banking, monetary policy.
They want to reinvent everything about money, but most of them are absolutely totally clueless. The ratio between arrogant and ignorant is astounding — I have never seen such a gap in my life. These are fanatics. Some of them, like criminals, zealots, scammers, carnival barkers, insiders who are just talking their book 24/7.
There is an element of excess in every bubble, but the typical bubble is an outgrowth of some technological evolution that maybe changes the world for the better. The internet was in a bubble in the late 1990s, but it was a real thing but valuations of many internet-related stocks were sky-high. Prices crashed and dot-coms went bust, but the internet kept on growing. Billions of people used it, and it has changed the world. Cryptocurrency as a technology has absolutely no basis for success, and the mother of all bubbles is now bust.
Twitter and in-person interactions with the fans of cryptocurrencies made me stronger and more secure in my belief.
Was there one specific cryptocurrency mania episode that stands out?
In the fall of 2017 when the bubble was in full swing, literally anybody I knew, even random people in the street, would stop me and the first thing they would say, “Are you going to be part of the crypto movement? Should I buy bitcoin?” This was a typical late bubble behavior when some unsophisticated investors who are total suckers hear about the bubble, they don’t even know what it is. That’s normal. Fear of missing out. And they jump on the bandwagon having no clue, and the insiders took complete advantage of these suckers at prices of $20,000 per bitcoin and similar junk. Millions of people lost their shirts buying at the peak only to lose 80% to 90% of their investment in the next 12 months.
When you see these sucker investors — in this case I call them the retail suckers — get into this FOMO frenzy, then you know this bubble is about to burst. So I saw it coming, even in terms of the timing of it.
The saving grace of cryptocurrencies is that, unlike other bubbles that exploded and led to some sort of a systemic crisis, this asset class was relatively small. Unfortunately, lots of suckers lost their shirts, but it doesn’t have any systemic implications.
What are some bubble-spotting tools? What does your crisis analysis framework involve?
It’s a combination of a scientific approach and an art. I’ve been studying bubbles and asset and credit bubbles and their busts and financial crisis for 30 years now.
You have to separate, say, a student debt problem from a corporate problem from a household debt problem from a banking problem from the problems of non-bank financial institutions or countries. This gives you the basis for assessing the vulnerability to a currency crisis, banking crisis, payments crisis, student debt crisis, corporate or household issues. Each one of them is different depending on the country, the situation. The excesses can be one sector or the other with multiple feedback loops.
There is, of course, a huge body of academic literature, which I have contributed to, like many others, on how to model the buildup of these financial vulnerabilities. Throughout history, we had thousands of empirical case studies of crises of all types.
Everything I learned over 30 years I put in Crisis Economics, where I begin by stating that crises are not black swans. Rather I call crises white swans.
What did I mean by that? My good friend and a brilliant thinker, Nassim Taleb, wrote Black Swan about the event that comes from the extreme tail of the distribution and cannot be predicted in advance but that everyone believes was explainable after the fact.
But for me, financial crises are not tornadoes or earthquakes that escape prediction. Financial crises are instead more like hurricanes that develop from a buildup of economic and financial vulnerabilities and policy mistakes that eventually reach a tipping point, a Minsky moment, when a buildup of excess debt and credit lead to excessive risk taking. The behavior of many participants in the system leads to a buildup of both asset prices and a credit bubble that gets out of control. At some point, shocks occur, and it is very hard to predict which shock will be the one, but eventually something will end the boom and the bubble will burst.
Now, getting it right in terms of the exact timing of the bust is not easy, but that buildup of financial vulnerabilities and policy mistakes doesn’t happen over six months. Usually it happens over a number of years. So if you are monitoring these excesses, you can see where there is a buildup of, say, housing and mortgage debt, a bubble that is not sustainable. So you can use a combination of theoretical models and empirical studies and then compare the buildup stages to other financial or credit bubbles. That is where the art of it comes, in addition to the science, to make a reasonable assessment of whether we are in the fifth, sixth, or seventh inning of that buildup.
Let’s say investors do see some bubbles on the horizon. They want to park their assets somewhere uncorrelated. Where should they look to diversify?
The point is that investors wish to avoid financial vulnerabilities. On one hand, they wish to stay invested, but on the other, they seek capital preservation should a significant downturn occur. Not just a 10% correction. Not even a 20% bear market, but something worse.
Savvy investors may be able to find ways to buy protection against extreme market drawdowns. It might be sophisticated “tail-risk” hedge funds that really try to provide the insurance against another global financial crisis. But you pay a premium in insurance-like payments for a long time to protect yourself against something that may come up only once every 10, 12, or 15 years.
Your friend Nassim Taleb has questioned whether the safe haven status of US Treasuries is justified. What’s your take? Do investors have viable alternatives?
One important investor belief is that equities bear the market risk, whereas bonds are assumed to be safe. The economic history suggests, and financial risks over the last few decades confirm, that even sovereigns can default. We have seen this in the emerging markets. I wrote a whole book about that, and now even some developed economies, under certain conditions, can be vulnerable to a debt crisis. This means, in the countries with an unsustainable level of public debt, that government bonds are not necessarily a safe alternative to equities.
Specifically in the US, our fiscal trajectory doesn’t look sound at all. The budget deficit this year is likely to be a trillion dollars and rising. Over the next decade, with the retirement of baby boomers, this gap is likely to get even worse. Therefore, our already high debt is going to get higher and higher.
In relative terms, the US is still in better shape than, say, Europe and Japan. Public debt as a percentage of the economy in most of Europe and Japan is higher than in the US. Potential growth is lower, and in the US, like in Japan, you can monetize your debt while individual members of the eurozone, like Italy, do not have their own currencies. Europeans can monetize debts across all members of the EU at the same time, but not individually.
That is why I don’t worry about the US fiscal climate in the short term, and even during the global financial crisis, US Treasuries and dollar assets became the safe haven. Remember that while the ground zero of the global financial crisis was here, the US government debt obligations were, in relative terms, perceived as safer than others.
However the US fiscal trajectory, if you take a medium- to long-term horizon of, say, 10 years, is not sustainable. So while they’re safe now, the much-needed change in fiscal policy that addresses the problem is unlikely given the lack of bipartisanship. I worry that the US will only deal with this problem when the crisis strikes many years from now. And it may take this kind of severe crisis to force politicians to address the problems. I don’t see this happening otherwise.
We have seen what market-imposed discipline can do in Ireland, Spain, Portugal, and Greece to force adjustments. There has not yet been market discipline in the US. Plus, the US dollar enjoys the privileged reserve currency status. What that means is that this particular can will be kicked far down the road. But the reckoning will eventually occur. I don’t expect this reckoning to take place in the next five years, but given current trends, give it 10 years, even the US fiscal outlook will become unsustainable.
So despite very real longer-term concerns, in the short- to medium-term, US debt will continue to offer some stability. Do you have other good news? What capital market developments are you most excited about?
I think that one of the most positives things is that there is a technological revolution that will probably change the world. It’s a combination of artificial intelligence, machine learning, big data, and the internet of things that is leading to a manufacturing revolution, a fintech revolution, a biotech revolution, and potentially an energy revolution
There are lots of major disruptions that are going to eventually increase productivity and create more goods and services. In that context, I would argue that the future of financial services has nothing to do with cryptocurrencies or so-called blockchain technology.
The real revolution in financial services is fintech, but fintech has nothing to do with crypto. Fintech is going be a combination of artificial intelligence and big data and the ubiquitous internet. It will revolutionize payment systems, credit allocation, capital market functions, insurance, investment management, financial advice, etc.
So that’s the good news. The bad news is that these technological innovations are capital intensive. This means if you are a venture capitalist, you will do great. If you are in the top 20% of distribution in terms of human capital plus skilled and educated, AI will make you smarter. You will be able to use these innovations to become more productive and make more money. But if you are a low- or even medium-skilled worker, or your job’s blue collar, then increasingly this technological revolution will threaten your prosperity. Therefore, I fear that income and wealth inequality will be getting worse.
We can see this already in the backlash against trade, against migration, against globalization. The big disruptions in the next 10 to 20 years are not going to be necessarily related to trade and globalization but to these technological disruptions, unless we find a way to broaden the human capital through education. We need to ensure that in the digital and AI economy, most people thrive. Or face a severe populist backlash in certain sectors or parts of the world.
So I’m a technological optimist. These news tools will revolutionize many aspects of our lives. So as consumers we’re all going to benefit. I am worried that as producers, some people are not going to have income and jobs to benefit from the cheaper goods and services, which will spark a lot of social unrest.
To conclude, Dr. Roubini, knowing what you know now, what advice would you give to your younger self?
One thing I see everywhere is a very low level of financial literacy. Most people don’t know basic economics and lack basic finance skills. Most of those people who were asking me, “Should I buy bitcoin?” did not even appreciate the difference between stocks and bonds or types of markets, or the basics of credit and interest rates.
This has two unfortunate consequences. First, people don’t save enough. If you don’t start saving when you’re young, you’re not going have enough retirement money to live comfortably in a world where life expectancy is becoming longer and longer. You have to start saving, because Social Security is not going to be sufficient.
Secondly, when they do save, people sometimes save in a reckless way. They buy risky things, they gamble, they trade too much, they go into stupid bubbles like bitcoin or the other fads of the day. An unsophisticated retail investor should save as much as they can. Invest in a diversified portfolio of mostly index funds and leave it alone. There is no reason to pay huge fees to hedge fund managers. Buy and hold equities with some allocation to liquid stuff and invest until you retire in a passive, low-cost index fund.
It doesn’t take a lot of sophistication, but most people don’t do it. So I wish there was a required basic course in college, if not earlier, in high school, on financial literacy, so that any young person knows it’s important to save and invest in an intelligent way. The stakes are high and if you make basic mistakes, they will cost a lot down the line. So that’s what I would give as advice to anybody.
For more from Nouriel Roubini, register now to hear him speak at the CFA Institute Equity Research and Valuation 2019 Conference this November in New York City.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image courtesy of Nouriel Roubini